Monetary Policy

Fida Hussain
Monetary Policy Department
State Bank of Pakistan

May 18, 2010

Outline

I. Contextualizing monetary policy

II. Monetary policy framework in Pakistan

III. Monetary policy formulation process

IV. How monetary policy works?

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I. Conceptualizing Monetary Policy

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Rationale for Economic Policy

 If every relevant good is traded in a market at publicly known prices, that is, if
there is a complete set of markets and information, and if households and firms
act perfectly competitively, then the market outcome gives the best possible
welfare enhancing outcome.

 Strictly speaking, this means that there is no role of government/policy, if the

highlighted conditions are met.

 But, as we all know, in real world these conditions are not met, which provides
rationale for government’s role in the economy and need for economic policy.

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When stabilization policies are needed

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Stabilization policies at work

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Monetary Policy: A component of economic policy

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What is monetary policy?

“Regulation of money supply and interest rate in the

economy to achieve economic goals”

Monetary policy involves central banks’ use of policy

instruments to influence interest rates and money supply to
keep overall prices and financial markets stable

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Objectives of Monetary Policy

 Price stability is becoming increasingly popular as principal objective;

 Other objectives include economic growth, full employment, exchange rate

stabilization, etc.;

 However, these ‘other’ objectives are being achieved through maintaining price
stability in the long run;

Price stability refers to a situation where inflation remains in a specific range

for a certain time period, say five years

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Why focus on price stability?
Consensus in economic literature (e.g. Barro, 1995; Fisher, 1994; Mishkin,
1999):

– Monetary policy can stimulate growth in short-run only but has lasting
impact on inflation;

– In long-run, there is no conflict between low inflation and fuller

utilization of resource—i.e. no inflation-unemployment trade-off;

– High and volatile inflation is detrimental to the economic growth;

– Low and stable inflation is necessary condition for sustained growth;

Price stability is means as well as end

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An example from “The History of Inflation in Turkey”

Inflation hits everyone …

Inflation: 18.9% 22.5% 62.0% 101.4%

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How high and volatile inflation affects growth?
 creates uncertainty about the future output and input prices and lowers the
quality of the signals coming from the price system;
 makes it impossible to plan for relatively longer outlook;
 creates incentives for households and firms to shorten their decision horizons
and to spend resources to manage inflation risk;
 diverts resources away from efficient production;
 discourages long term contracts (due to uncertainty) and resources are
wasted on frequent negotiations;
 undermines confidence in domestic currency;
 impacts more severely low income strata than the people in high income
brackets.

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Case of Pakistan

Long Term Trends in Inflation and GDP Growth

GDP Inflation
14
High inflation
12

10
percent

4 Low growth

2
FY51
FY54

FY60
FY63
FY66

FY72
FY75
FY78

FY81
FY84

FY93
FY96

FY02
FY05
FY57

FY69

FY87
FY90

FY99
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II. Monetary Policy Framework in Pakistan

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 Contours of monetary policy framework in Pakistan
• Objective(s) of SBP’s monetary policy is to achieve price stability while keeping an eye
on economic growth.

• Targets of average CPI inflation and real GDP growth are set by the government and
announced prior to the beginning of a fiscal year.

• The targets for CPI inflation and real GDP growth provide a basis for setting an indicative
target for M2 expansion, which serves as an intermediate target.
 For instance, if given targets for inflation and growth are 10% and 3%, the M2
target is roughly 13%

• Indicators are available information on the components of M2 and their projections are
used in understanding and analyzing interactions of the monetary sector with the real,
fiscal and external sectors of the economy.

• Monetary policy instruments are used to influence interbank and other market interest
rates, starting with the overnight money market repo rate, SBP’s operational target.

• Change in the monetary policy stance is signaled through adjustments in the policy rate.
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Monetary Policy Instruments in Pakistan
Policy Rate
• Discount rate or SBP reverse repo rate—the rate at which
commercial banks borrow from the central bank. Currently, it is 12.5
percent per annum w.e.f 17th August 2009.
 SBP repo rate, on new SBP deposit facility, which is 300 bps
below SBP reverse repo rate.

Open Market Operations

• It is a flexible market-based instrument for short term liquidity
management intended to support SBP’s policy rate and stance.
• To drain liquidity SBP sells T-bills to commercial banks generally with
a re-purchase agreement (repo).
• To inject liquidity, SBP purchases T-bills from commercial banks
generally with a re-sale agreement (reverse repo).
• Outright sale and purchase of T-bills 16
Monetary Policy Instruments (cont…)
Cash Reserve Ratio (CRR)
• It is a ratio by which commercial banks are required to keep a certain
portion of their liabilities with SBP in cash at zero return.
• Currently it is 5% for demand liabilities (including less than 1 year
time deposits) and 0% for time liabilities of above 1-year tenor.
Statutory Liquidity Ratio (SLR)
• It is a ratio by which commercial banks are required to keep a certain
portion of their liabilities in the form of government securities
• Currently, it is at 19% for demand liabilities (including less than 1 year
time deposits) and 0% for time liabilities of above 1-year tenor.
Forex Swaps
• These are transactions of SBP in the foreign exchange market
• Swaps are similar to repo operations described above.
• Purchase of dollars results in injection of Pak rupees, while selling of
dollars drains Rupee liquidity. 17
III. Monetary Policy Formulation Process

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 Monetary policy formulation process
 Employing the framework highlight above, the draft of the Monetary Policy
Statement (MPS), which summarizes all the relevant information, analysis, and
projections, is prepared by the Monetary Policy Department of SBP.
 Earlier, the MPS was issued on a quarterly basis. Starting current fiscal year (FY10),
two comprehensive (in January and July) and four brief statements (in March, May,
September and November) will be issued.
 This draft MPS is circulated among the SBP’s senior management, including
Governor, to initiate debate and to get their feedback and suggestions.
 The senior management discusses the policy proposal(s) based on the analysis in the
draft MPS to build consensus on the appropriate monetary policy stance.
 After discussion and finalization of the proposed policy measures, draft MPS is
presented in the sub-committee of the SBP’s Central Board of Directors – the
Monetary Policy Committee (MPC)
 After approval from the sub-committee, the same is presented in the meeting of the
SBP’s Central Board of Directors for its final approval.
 After this, the Governor usually holds a press conference and announces the policy to
the general public. SBP staff and Governor then give interviews on the media to
explain the policy stance further. 19
Policy rate is changed keeping in view trends in inflation
and other key macroeconomic variables…

Generally, interest rates are allowed to go down if:

 Inflation is decelerating or is at a level that is much lower than the target
and growth outlook is significantly below potential growth;

Generally, interest rates are allowed to go up if:

 Inflation is accelerating (or higher than its target) together with actual
growth near the potential.

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IV. How Monetary Policy Works?

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Transmission mechanism of monetary policy

The process through which monetary policy

decisions affect the level of economic activity and
inflation rate in the economy.

Understanding the transmission mechanism of

monetary policy is crucial for appropriate design
and efficient conduct of monetary policy.

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From operational target to objectives
 Monetary policy affects the goal variables (i.e. inflation and growth)
through adjustment in aggregate demand brought about by changes in
interest rate and money supply in the economy.

 The changes in policy rate, affects the interbank and other retail interest
rates in the economy directly as well as through changing the
‘expectations’.

 The resulting changes in retail interest rates affects the consumption and
investment behavior of the economic agents and thus, the level of
aggregate demand in the economy.

 Finally, the adjustment in aggregate demand affects the general price

level and thus inflation in the economy.

Bottom Line: Both the current as well as the expected monetary policy
stance are important in influencing the economic behavior and
controlling inflation. 23
Transmission Mechanism-a graphical depiction

Market
interest rate
Structure

Monetary
Monetary and Credit Aggregate Domestic Aggregate
Policy Actions Aggregates Demand Goods Prices Output
- Current
- Expected
Asset Prices

Imported Aggregate
Exchange Goods Prices Prices
Rate
Monetary
Policy
Objectives

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Time lags in monetary transmission
 Monetary policy shocks require a considerable time before the consequences
of a policy action can become perceptible on inflation and other key
macroeconomic variables.

 Empirical evidence indicates that there is a 6-24 months time lag in

developing economies in the transmission of monetary policy impact on
inflation.

 In Pakistan, this transmission lag is estimated between 12-18 months.

Bottom line: As monetary policy actions affect goal variables with a considerable
lag, it is important to predict the future course of the goal variables and
possible impact of policy actions on the real variables.

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Conclusion: what monetary policy can and cannot achieve
 Monetary policy plays a central role in reducing inflation and keeping it at
moderate or low levels, broadly termed as price stability.

 Overall monetary policy strategy is a crucial element in ensuring financial

stability.

 An expansionary monetary policy can stimulate economic activity only in

the short run, that is, when actual output is much below potential and
inflation is low.

 Monetary policy cannot increase the country’s capacity to produce goods

and services.

 Monetary policy has a lasting effect on inflation but only a transient effect
on output.
Bottom Line: Monetary policy is a stabilization/aggregate demand
management policy and can not impact long-term growth potential. 26
THANK YOU

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